How can microloans achieve their aim?

Microloans are currently regarded as one of the most promising ways of encouraging entrepreneurship and combating poverty. Statistics show that the majority of the loans are repaid. We can therefore conclude that the system works. But is this actually the case?

Not all borrowers are alike

For his PhD, Jacob Vermeire spent a year in South Africa. “While I was there, I witnessed first-hand how microloans which had been granted for business purposes were also used for personal expenses – even the larger microloans, which you would logically assume were intended to support a business. After all, these are the showcases of the microfinance institutions”, he says. “Hence my research question: how do people use their microloans and why? Some people mainly use the money to run their business and invest in stock, raw materials, machines, personnel and so on, while other people mainly spend it on household expenses – school for the children, the house, a fridge… Why the difference?”

Seven women

Jacob examined microloans provided by the Small Enterprise Foundation (SEF), a microfinance institution in South Africa which works to eradicate poverty by fostering entrepreneurship. He shadowed seven women who were SEF clients over a one-year period. “The data for my study came from comprehensive interviews with both the women and their case managers, plus daily observations and information from SEF's files. Seven cases might not seem much, but it is a common number for this type of study. If you don't know in advance exactly where to start when identifying (good) conduct, it's a good idea to try to understand the social situation in all its complexity. In that case, you need to restrict yourself to a smaller group.”

Money from your grandmother

50 euros is 50 euros. Money for your company is money for your company. It might seem simple, but it isn't. Where the money comes from determines how you think of it. “If I get those 50 euros from my grandmother, I will be more likely to spend it on myself, on something I've been wanting for a long time. However, a 50 euro wage increase will simply end up in the household budget,” explains Jacob. “I noticed the same thing during the study: people who regarded SEF as more of a loan shark, a commercial lender, mainly tended to spend the money on the business. People who compared their relationship with SEF with that of the relationship with their spouse mainly tended to use the money for household expenses.”

Ambiguous message

SEF grants microloans to allow borrowers to set up or expand a company. When applying for the loan, clients must complete a form in which they specify what the money will be used for. In theory, everything seems to be formalised in such a way as to ensure that the funds will actually be used for business purposes. However, Jacob feels that SEF communicates in a manner which could be described as ambiguous at the very least. “Their vision and mission leave scope for interpretation – they feel that entrepreneurship is important, but also wish to eradicate poverty from the world. For people who are living in poverty, entrepreneurship does not necessarily mean the same as improving their precarious financial situation. During their training, the SEF case managers are also told that most of the money must be used for business purposes, but not all of it. As a result, they are explicitly told they can overlook the improper allocation of the funds. In addition, the case managers have generally experienced poverty themselves, so they understand if someone uses the money for personal expenses.”

In other words, the message is ambiguous. All the same, some women invest the money exclusively in their business, while others regard the business as an afterthought. The same message, interpreted differently. How do you explain that?

Who am I?

“To answer this question, you need to look at a person's dominant social identity,” explains Jacob. “Your social identity is the part of your self-image, which is determined by membership of a particular group. The two identities which are relevant to this study, and which are at odds with each other, are those of entrepreneur or businesswoman and family member. Given a context of scarce financial resources, a microloan is one way of realising your dominant social identity.”

It is this dominant social identity which determines what the money is spent on. “The women who exclusively invest the money in their business regard themselves as businesswomen, and the others primarily regard themselves as family members. The dominant social identity is also influenced and strengthened by your surroundings. The businesswomen mainly tend to set up their business outside the home. They are therefore using the money in an environment where all kinds of factors constantly reaffirm their identity as entrepreneurs, such as the presence of staff and the appearance of their workplace. The women who mainly use the money for personal ends have set up their small business at home.”

A downward spiral

Most of the studies on microcredit financing look at the statistics – the number of cases, amounts granted, repayment percentages, socio-economic impact etc. Jacob was one of the first people to examine the actual use of microloans.

Why is this important? “The interest rates and repayment methods of microloans assigned for business purposes assume that the micro-enterprise will yield definite returns fairly quickly. The returns on the profitable sale of fruit and vegetables or clothing can't be compared with that of a good school education, which will only pay off in the much longer term. Money spent on a refrigerator for your own personal use will not bring in any returns; this money has been lost. In such cases, the microloan is often repaid with money borrowed from family members, or worse, from other lenders at impossibly high interest rates. Microfinance institutions are not always aware of the problem as the money is repaid, but sometimes poor people end up getting even further into debt as a result, and that is absolutely not the intention.”

Diversify and become more professional

Jacob therefore has important advice for socially committed microcredit providers: “Identify your target group, formulate clear objectives and make sure you also communicate them unambiguously. And monitor the use of the financial resources. Asking applicants to complete a form when applying for a loan isn't going to achieve much if you don't follow up on what happens with the money afterwards.”

“Poverty can be fought in various ways: by encouraging entrepreneurship, by investing in education and healthcare, by setting up programmes which promote social inclusion... Both borrowers and lenders benefit from a differentiated approach. Fostering entrepreneurship requires a different approach than investing in education,” he concludes.

What’s in a name?
Microloans are relatively small loans which are granted to poor people who are not eligible for a conventional loan from a commercial bank. The loans are intended to be used for setting up and expanding a business. They generally have a short duration, e.g. six months, and monthly repayments. They are mainly granted to women. No security is required but the borrowers generally belong to a specific group. Although the loans are granted to individual borrowers, the assumption is that pressure from the group will ensure that the loans are ultimately repaid in full.

Source: ‘Fool, Founder or Family Member? The Role of Social Identity in Explaining the Social Meaning and Allocation of Financial Resources’ from ‘Understanding Microfoundations of Entrepreneurship Development in Sub-Saharan Africa’ by Jacob Vermeire. PhD in Applied Economics at Ghent University in 2017. Supervisor: Professor Miguel Meuleman (Ghent University, Vlerick Business School and Imperial College Business School).